What to Look for in an IPO

Earnings, cash flow and revenue growth are the most important criteria

stocks riseMany individual investors consider initial public offerings (IPOs) as the holy grail of equity investing — as though getting in relatively close to the ground floor on a new stock assures that it will only appreciate in value. However, the Facebook IPO in 2012 (where the stock’s closing price was only $0.23 higher than its initial offering price) showed that as with any kind of investing, getting in on an IPO guarantees nothing.

BE spoke with Brian Hamilton, Chairman of Sageworks, to find out what sort of things should individual investors look for before buying into an IPO. Sageworks provides private company financial information and develops financial analysis and risk management solutions. The first theory to dispel is that the individual investor is getting in on the ground floor. “The average retail investor is getting in on ‘the fifth floor’ in most cases, not the ground floor,” asserts Hamilton. “Take Twitter for example: The IPO Price was technically $26, but by the time retail investors got a chance, the stock was at $45. Executives, VCs, underwriters, and the rest of the “smart money” are on the ground floor, not the average investor.”

According to Hamilton, there are a few core financial principles which are applicable to the evaluation of all companies, regardless of size, market cap, and number of employees. He recommends the following checklist:

“Is the company profitable? Does it have a healthy cash flow? Is its rate of sales growth consistent or hopefully growing? If the answer is ‘no’ to any of these questions, that’s a red flag that needs to explored more thoroughly,” he asserts. “It’s also incredibly important to look at trends, not snapshots in time, for these metrics. You can learn a lot more by looking at ratios over time, than ratios at one point in time.”

IPOs provide a rare chance to peek into a private company’s financials (as required by their S-1) before they’re traded on the market. With access to the financial statements of a company’s going public, you essentially have the answers to the test. Hamilton recommends going through this same checklist, while looking at the company’s income statement, balance sheet, statement of cash flows, etc. The value of any company (public or private) is a function of the cash flow it will generate in the future.

“It’s my strong recommendation that when evaluating companies (IPOs in particular), one should be incredibly skeptical of any ‘future’ projections that are not in sync with past performance. Look at what a company has actually done, not what it says it will do.”

Regarding the recent IPO for Twitter: “Investors should be very concerned, in my opinion, when they see a newly public company (like Twitter) without profitability. A healthy profit margin is, in many ways, like an insurance hedge,” he asserts.

“Profits are a cushion for companies, helping to soften the blow in case revenues begin to slip,” says Hamilton. “It’s also a key indication of whether or not a company’s leadership has been able to effectively manage growth. There are companies that have succeeded with consistently low profit margins (like Amazon), but they are exceptions, not models for emulation.”

Just because you’re not getting in on the ground floor doesn’t mean that all IPOs are inherently bad investments.   “However, we’re seeing a recent trend of high profile IPOs, particularly tech IPOs, being valued very dangerously,” Hamilton says. “There’s an important distinction between a “hot” company and a financially sound company. If a company is going public, and that company is showing solid sales growth, healthy cash flow and (perhaps most importantly) the ability to turn a profit, then that IPO may be a sound investment opportunity. However, I’d strongly urge individual investors to look at a company’s fundamentals, and not just the hype surrounding the company, when considering whether or not to invest (or attempt to invest) in an IPO.”

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